The de-risking process for “concept stocks”

The de-risking process for “concept stocks”

I recently pointed out that around two-thirds of the 2,000 companies listed on the ASX are unprofitable. In this blog I thought it might be useful to focus on pre-profit companies, together with a handy list to assist investors to discern the wheat from the chaff.

The question is when does a company transition from a “concept stock”– mostly pursued by speculators – to an “investment stock”? In other words, when is an investor comfortable a company is increasingly likely to survive and thrive, without relying on its shareholders being tapped on the shoulder for additional capital during the “cash burn” phase?

The steps along the risk curve include:

1. Regulatory approvals. I see a lot of exploration companies and medical device companies, for example, that remain “concept stocks” awaiting various regulatory approvals.
2. Production facilities for reliable delivery of the company’s good or service. The logistics of getting the product or service to the customer is often much more complicated and costly than anticipated.
3. Trustworthy and purposeful staff to keep the wheels turning whilst the company is burning cash. During the “cash burn” phase, there are a multitude of bumps along the road, and being on the front-line, staff are too often over-looked.
4. Sufficient capital to survive the inevitable delays and surprises. The company must be able to “sell the concept” to the shareholders. Communication is crucial as long delays harm credibility, often resulting in a loss of shareholder patience. Additional capital is then required generally at lower share prices, often diluting the more fatigued shareholders.
5. Well regarded management/ directors as all stakeholders are taking a risk during the “concept stage” including staff, customers, shareholders, creditors and bankers. This is crucial. I have seen too may examples of management/ directors setting a poor example by rewarding themselves far too generously during the “cash burn” phase.
6. Strong accounting and operational practices to keep on top of the drivers. A major challenge during the “cash burn” phase is the ability to spend scarce capital on the most productive areas of the business. Knowing when to accelerate the hiring of additional staff, particularly in the sales, marketing and customer relationship area is important.
7. Growing revenue to a level which exceeds costs on a sustainable basis. There is frequently tension between additional revenue and “the cost of growth.” For example, if the cost of an additional $1 of revenue exceeds $1 to produce that revenue, then the company is soon back to its shareholders for more capital. The “cost of growth” is often under-estimated.

Transitioning from a loss-making “concept stock” to an “investment stock” is often a subjective matter, however analysis of the seven points above is worthwhile for speculators looking for a de-risking process. Investors will generally be rewarded with exciting share price gains as the company in question de-risks – providing your timing is good!

You can read my recent article here: ASX Listed Small Companies – discerning the wheat from the chaff

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Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.